Layer 1 Blockchains: A Tale of User-Owned Cities, Part II of II

Last Update 06/14/2023

In part one of this two part series, we covered how Layer 1 smart contract blockchains are like software versions of cities in that they are the foundational infrastructure for user interactions–in this case, decentralized applications (dApps). As a result of these structural differences, various smart contract blockchains are tailored towards different kinds of cultures, users, and activities.

Building on the foundation laid by part one, this piece will serve to answer some of the following questions: Which chains are producing the most user traffic? Which chains are generating revenue and have the most developer activity? Which chains are best positioned towards the future in the face of market headwinds?

In the sections to follow, we’ll evaluate performance metrics and break down adoption progress between smart contract blockchain applications across Decentralized Finance (DeFi) and consumer dApps in order to draw conclusions about these protocols and the space going forward.

Progress and Positioning

FIGURE 1: Key Metrics for Layer 1s in Q1 2023 (top 5 by market cap)

Sources: Messari, Defi Llama, Electric Capital, Coinmarketcap

The structural differences between Layer 1s are apparent as demonstrated by the Q1 2023 key metrics shown above (FIGURE 1). Outliers indicate the variability in strength and adoption of each protocol. For example, Solana’s extremely high transaction volume indicates its value proposition towards transaction-heavy use cases like gaming and NFT mints. On the other hand, Ethereum significantly outpaces the rest in terms of revenue (over 4x the next alternative) and also total value locked (TVL, ~6x larger than the next alternative), which has attracted financial applications that require large amounts of liquidity for various use cases like trading.

Protocol Utilization

FIGURE 2: Daily Active Addresses (YTD)

Sources: Etherscan, Polygonscan, Snowtrace, Artemis.xyz

FIGURE 3: Q1 2023 Transactions

(Transactions in mms), Sources: Messari, Etherscan

So far this year, Ethereum and its scaling solution Polygon have consistently led competitors in terms of overall activity (see FIGURE 2). Ethereum Layer 2 Arbitrum (in particular) began to show significant activity (in part due to its airdrop) starting in March. We believe it will be worth monitoring going forward to see whether or not Ethereum Layer 2s continue to compete with top Layer 1s on activity despite having launched more recently.

While Solana had an influx of users in May, it really shines in terms of transactions processed. FIGURE 3 illustrates the extent to which Solana continues to dominate due to its throughput capabilities. As a result, we believe Solana is positioned to be the go-to chain for transaction-intensive applications. This is unlikely to change among major Layer 1s in the near future without fundamental protocol changes and alternative tradeoffs in the blockchain trilemma¹. In stark contrast, Ethereum trailed competitors Avalanche and Polygon in transactions in Q1 2023 even when accounting for all Ethereum ecosystem Layer 2 activity.

DeFi and Stablecoins

In part I, we covered how Ethereum acquired a reputation for relatively high fees and slow transaction rates. Despite this, it appears to remain the champion of DeFi. Ethereum continues to benefit from the fact that the most popular and utilized DeFi protocols were originally launched on its chain. If New York is the home of finance, Ethereum is certainly the home of DeFi.

FIGURE 4: Total Value Locked (TVL)

Sources: DeFi Llama, The Tie, between 6/1/22 and 6/1/23

When measuring DeFi utilization on a particular chain, we often turn to TVL, the total value of assets “locked” into a particular chain–whether via lending, staking, or as a liquidity provider. In large part due to top DeFi protocols including Lido, Maker DAO, and Uniswap, Ethereum accounts for ~$27bn TVL and ~57% of total TVL² of all smart contract blockchains. Meanwhile Polygon and Avalanche each account for ~$1bn and Solana trails with ~$280mm.³

Ethereum also has a significant advantage in terms of stablecoins, as the stablecoin market cap on Ethereum is currently $69bn while all other Layer 1 competitors are each under $3bn⁴. As a result of this, and because stablecoins serve as the primary source of liquidity in crypto, Ethereum is likely better positioned than L1 competitors to perform with resilience in the face of a potential economic downturn.

In the wake of FTX, bank failures like Silicon Valley Bank and Silvergate, and regulatory pressure on centralized exchanges, transaction volume has moved from centralized exchanges to decentralized exchanges⁵. As a result, Ethereum’s DeFi ecosystem has been able to benefit, led by Automated Market Makers⁶ such as Curve and Uniswap, each of which account for $3.5bn TVL. In total, Ethereum generated over $214bn in Q1 2023 DEX transaction volume, orders of magnitude larger than Polygon ($20bn), Avalanche ($8.5bn), and Solana ($6bn)⁷.

So why does Solana, the highest throughput and lowest fee platform, currently trail behind slower competitors like Ethereum in terms of DeFi? In this case, Solana’s relatively close ties with FTX are part of the story; the platform lost significantly more TVL and market share in comparison to other Layer 1s following the exchange’s collapse last November⁸. But then why does Ethereum—the lowest throughput, highest fee platform—dominate in DeFi? There are a number of possible factors at play which may include, in addition to other factors:

Network effects as traditionally more people use Ethereum; this translates to more liquidity relative to other chains, giving Ethereum a significant advantage towards capturing newcomers⁹.
Lindy Effect¹⁰ with Ethereum, which has been around longer than its competitors and was the chain that introduced DeFi into the world.
Higher level of trust in the security of Ethereum as it is structurally imbued into the functionality of the protocol with its high fees serving as incentives for validators.

Consumer Segment, NFTs and Gaming

While Ethereum significantly outpaces competitors in DeFi, the consumer and gaming segments are more of a level playing field. Because of Ethereum’s deep network liquidity and high transaction fees, it lends itself to expensive transactions and premium brand projects. On the other hand, lower fee, higher speed chains like Polygon and Solana fit well with applications that are transaction intensive and cheaper on a per transaction basis.

While Ethereum holds the majority of NFT trading volume (again underscoring the depth of its liquidity advantage), other chains are competitive, with Solana at second place and Polygon in third. Ethereum’s high fees have conveniently aligned with the scarce, pricey NFT collections that some have likened to “luxury brands” such as the Bored Ape Yacht Club and Cryptopunks. Time will tell whether these brands will be able to further provide utility and engagement with their community with potential immersive games and experiences; doing so successfully could greatly enhance the long-term competitiveness of Ethereum’s gaming ecosystem.

In terms of institutional onboarding, Polygon appears to have become the lead partner to legacy web2 consumer brands. In the past nine months, Starbucks successfully launched its Odyssey rewards program NFT collection¹² and Nike launched its .SWOOSH platform¹³ for virtual apparel on Polygon. Notably, Reddit minted over 10mm “digital collectibles” on the network, leading to $32mm in secondary sales volume¹⁴. The common thread between the many large consumer brand launches on Polygon is that none of them mention the term “NFT.” Instead they emphasize phrases like “membership token” or “digital collectible.” We believe the potential to onboard consumers to blockchain here is enormous as trusted institutions offer new forms of customer experiences in a way where users don’t even need to know that they are using the blockchain on the backend.

Games based on the Solana network like Star Atlas, Stepn, and Aurory have yet to truly fulfill hype and potential outside of the small crypto-gaming community. However, Solana is the one chain that is functionally capable to process users at a large scale right now. Below is a snapshot of how much it would cost for a creator to mint 1 million NFTs on various chains:

FIGURE 5: Cost to mint 1 million NFTs on various Layer 1s

Source: Solana.com as of 6/1/23

Outside of gaming, Solana has also found early traction in the space of Decentralized Physical Infrastructure (DePIN)¹⁵. Over 350K individuals around the globe have chosen to run physical Helium nodes to provide mobile hotspot coverage to others. The application of crypto to real world physical infrastructure is directly enabled by Layer 1 smart contract functionality and is a space to continue to monitor. Because of Solana’s technical performance capabilities, it can enable a broad range of potential consumer applications to run on-chain, from DePIN to gaming, decentralized social media and mobile messaging.

Going Forward

In the future, we believe there likely is a large opportunity for protocols that provide the best infrastructure for dApps serving high-opportunity emerging use cases. For example, if Avalanche could position itself as the go-to option for dApp developers of Real World Assets (RWAs)¹⁶, it could reap significant value by onboarding financial firms via the tokenization¹⁷ of traditional financial assets. The same could be said in other areas such as DePIN for Solana and web2 consumer brands for Polygon as well.

In the long term, regardless of positioning for adoption, technical innovations will likely always remain paramount. In this vein, protocols like Polkadot, Avalanche, and Cosmos that provide developers with autonomy and also tooling for interoperability will become increasingly critical if crypto is able to realize its potential of a multi-chain future. In the near term however, assets are not easily portable across chains. As a result, particularly amidst regulatory and market uncertainty, we believe the market will reward Layer 1s that (1) are able to own a customer segment via unique use-case dApps and (2) are able to withstand market volatility with ecosystem liquidity.

Conclusion

In part because of the fundamentally different structures, use cases, and strategic positioning of each Layer 1 network, it is our view that ultimately there will not be a winner-take-all dynamic among smart contract platforms. Instead, we believe there will be continuous opportunities for new entrants and developing blockchains that target particular end-users. Some chains like Avalanche are potentially positioned better to be more institutionally friendly in terms of developer customizability, resource allocation, and partnership efforts to onboard traditional financial institutions. High transaction, low fee chains like Solana and Polygon are likely to continue to compete for market share in the gaming and NFT sectors, while challengers will need to make up ground in terms of developer tooling, platform trust, liquidity, and security to hope to compete with Ethereum in DeFi. We believe the extent to which these chains capture and serve existing crypto users as well as onboard new user demographics in their specific niches will significantly impact the eventual dominance hierarchy of Layer 1s.

Similar to the dynamic between Bitcoin and other tokens, generally, Ethereum has no doubt capitalized on its first mover advantage among Layer 1 smart contract blockchains, enough to attract almost 3x as many developers into its ecosystem as the next competitor (see FIGURE 1). Because of the developer interest in improving Ethereum itself as a protocol and in building blockchains and dApps on top of the network that can rely on its security, we believe Ethereum is well positioned to realize its vision of becoming the most trusted settlement layer in crypto–even if much of the activity ends up on scaling solutions. Today, most of the value in crypto lies in the underlying protocols rather than specific applications built on top of them. While this notion, commonly referred to as the Fat Protocol thesis, holds true today, it is uncertain whether this would remain true at mainstream levels of application adoption.

Regardless, if we’ve learned anything in crypto, it’s that things change extremely quickly. No advantage is necessarily sustainable in the long term. Because of the ability of developers to fork code and start a new blockchain, there is much less of a proprietary technical moat in crypto. This lowers the barrier to entry. Recent entrants like Aptos and Sui may start at a deficit in metrics early on but that may be completely different in a year from now. Perhaps just as important, smart contract blockchains have arguably yet to truly find product market fit at the dApp and consumer level. As a result, there may be a large opportunity for developers who are able to alleviate user pain points like UX, fees, and onboarding. Though it is difficult to see any chain challenging Ethereum DeFi in the near term, we believe Solana is well positioned to lead Layer 1s in consumer via on-chain gaming.

In the end, there may be multiple winners engaged in constant competition for market share. As New York City, Los Angeles, San Francisco, and Chicago vie for talent in terms of businesses and residents, so too will Layer 1s. Ultimately, we believe that this natural competition among chains will create an assortment of desirable structures, features, and products. Along these lines, in the early 1800s Napoleon declared¹⁸ the following:

“A revolution can neither be made nor stopped, the only thing that can be done is for one of or several of its children to give it a direction.”

We think that in some ways this idea (as crypto is in some ways a bottom-up revolution) applies here. We argue that ultimately crypto is similarly an emergent phenomenon and represents a paradigm shift away from dynamics that tend to occur in web2 (such as user-value extraction and value accrual towards the top) and towards increased competition and innovation with a greater benefit to all participants. Layer 1s are–and will continue to be–a driving force in the direction of this shift.

^{1. Refers to the challenge of achieving a balance between decentralization, security, and scalability in blockchain technology.}

^{2. Ethereum TVL comprises all the TVL of the dApps built on its network.}

^{3. DeFi Llama}

^{4. DeFi Llama, as of 6/1/23}

^{5. Coin Telegraph}

^{6. A dApp that enables the execution of token trading, lending, and liquidity providing.}

^{7. DeFi Llama}

^{8. Coinmarketcap}

^{9. Note the importance of liquidity: There are slippage benefits for AMM traders if there is more liquidity & users can borrow more.}

^{10. Popularized by Nassim Taleb, the Lindy effect suggests that the longer something has been around and has proven its viability, the longer it is likely to remain relevant and endure into the future.}

^{11. Flipside Crypto, Messari}

^{12. Decrypt and Forbes}

^{13. Decrypt}

^{14. Dune Analytics}

^{15. A network of physical nodes, assets, or facilities that operate on a decentralized blockchain platform, enabling autonomy, transparency, and resilience in various industries.}

^{16. Real-world assets (RWAs) are physical assets that exist in the physical world, such as real estate, commodities, or financial instruments, and can be tokenized and put on a blockchain.}

^{17. Tokenization is the process of converting assets, like money or property, into digital tokens on a blockchain.}

^{18. The Mind of Napoleon: A selection of his written and spoken words}

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